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ETF Specialist

Not All Index-Tracking Funds Are Created Equal

This Gold-rated exchange-traded fund offers exposure to U.S. small-cap stocks on the cheap.

Index-construction differences among market-cap-weighted funds can materially impact performance in the small-cap arena because market impact costs are more meaningful. For example, the Russell 2000 Index's popularity and lack of buffering rules have contributed to its chronic underperformance compared with other popular small-cap U.S. stock indexes.

On the other hand, funds tracking less popular small-cap indexes that employ buffering rules to limit turnover should have a leg up over the long haul.

 Schwab U.S. Small-Cap ETF (SCHA) does just that by tracking the Dow Jones U.S. Small-Cap Total Stock Market Index. This is a market-cap-weighted fund that accurately reflects the U.S. small-cap stock market. Its efficient index construction, well-diversified portfolio, and low fee should continue to provide an edge over its peers, supporting a Morningstar Analyst Rating of Gold.

The fund offers well-diversified exposure to U.S. small-cap stocks by tracking the Dow Jones U.S. Small-Cap Total Stock Market Index. The index represents the bottom 15% of stocks by market cap in the total U.S. investable stock market. It holds about 1,750 stocks and extends further down the market-cap spectrum than its typical peer. But its average market cap is 20% larger than the Morningstar Category average's, likely because of a market-cap-weighting approach that pulls the portfolio toward the largest small-cap stocks.

Small-cap stocks tend to be riskier than large caps but can offer higher potential returns and diversification benefits. The fund only screens on size, so it provides truly passive exposure to U.S. small-cap stocks. The fund has a couple of advantages that should reduce its transaction costs, which is important because smaller stocks tend to be more expensive to trade. First, it tracks a less popular index than peers, so there's less demand for liquidity when stocks are added or removed from the index. And its index applies buffer rules to mitigate unnecessary trades. These buffer rules, together with the fund's broad market-cap-weighting approach, have kept turnover well under the small-blend category average.

From its inception in November 2009 through December 2017, the fund bested the small-blend category average by 1.6 percentage points annually with similar risk. Much of this outperformance can be attributed to the fund's persistent low-cost advantage. Because this index fund is always fully invested, it may suffer deeper drawdowns than the average fund in the category during bear markets. But its smaller cash drag should pay off during bull markets.

Fundamental View
Small-cap stocks tend to be riskier and less profitable than mid- and large-cap stocks because they have less-established competitive advantages and they're more sensitive to the business cycle. But they offer diversification benefits and may compensate investors with higher returns. Over the very long term, small-cap stocks have generated higher returns than their larger counterparts, but they can experience decade-long stretches of underperformance.

The case for indexing small-cap stocks boils down to two considerations: costs and whether that index represents its peers' opportunity set. Index funds usually charge lower fees than their actively managed counterparts because their sponsors don't have to pay portfolio managers and investment analysts to identify under- or overvalued stocks to be added to or sold from their portfolios. So, if their portfolios are representative of their active peers (as this fund's is), they should do better than average net of fees. Additionally, market-cap-weighted index funds enjoy low turnover, which mitigates transaction costs. But market-cap-weighted index funds have some drawbacks. They rely on market participants to incorporate information into stock prices. While market participants have done a good job of valuing stocks over the long term, the market has gone through episodes of mania and panic. Also, by design, market-cap weighting increases the fund's exposure to stocks as they become larger and more expensive, and it reduces exposure to names as they become smaller and cheaper, which may have higher expected returns. Finally, index funds are always fully invested. During bull markets, that can help performance, but it can hurt during market downturns.

This broad market-cap-weighted portfolio offers efficient, well-diversified exposure to small-cap stocks. Its top 10 holdings represent around 3% of the portfolio. Because the Dow Jones U.S. Small-Cap Total Stock Market Index is not widely followed, the market impact costs to move securities into and out of the index are lower than the costs that some of its more popular peers incur. The underlying index introduced more-stringent liquidity requirements in June 2015. Now 10% of a stock's shares must trade publicly before it can be added to the index

The index uses buffer rules to reduce unnecessary turnover and transaction costs. At its annual reconstitution, currently held stocks are favored over new stocks that may better fit the fund's size criteria. The index still invests in small-cap stocks but isn't forced to trade stocks that barely cross the index's market-cap size thresholds. Market-cap weighting skews the portfolio toward the larger stocks in the small-cap segment. Indeed, the fund's holdings' average market cap is 36% larger than the category norm. This weighting approach also allows market prices to determine the portfolio's sector weightings, which differ a bit from the category average. The fund has greater real estate and healthcare sector weightings and less exposure to the industrials, consumer discretionary, and financial-services sectors.

Portfolio Construction
SCHA tracks an index that effectively diversifies risk, promotes low turnover, and accurately represents its target market segment, supporting its Positive Process Pillar rating.

The fund tracks the Dow Jones U.S. Small-Cap Total Stock Market Index, which ranks U.S. stocks by market cap, excludes the largest 750 stocks, and targets the next largest 1,750. But when it reconstitutes each year in September, current holdings that rank between the largest 601st and 3,000th by market cap are included first to reduce unnecessary turnover. Like most index peers, the fund adjusts its holdings' weightings to reflect free-float market capitalization. In June 2015, the index began requiring new constituents to have 10% of its shares publicly traded to be included. New stocks must also pass a minimum trading volume threshold. Current holdings do not have to pass these liquidity hurdles.

The fund levies a 0.05% fee, which is lowest in the category, warranting a Positive Price Pillar rating. This expense ratio is a fraction of the 1.04% median levy that its category peers charge.

During the trailing three years through December 2017, the fund outpaced its benchmark by 1 basis point per year. This implies that the fund has been able to more than offset some of the drag created by its fee through a combination of savvy portfolio management techniques and securities lending.

Investors looking for a dedicated U.S. small-cap index fund have several attractive options to choose from, including  iShares Core S&P Small-Cap ETF (IJR) (0.07% expense ratio) and  Vanguard Small-Cap ETF (VB) (0.06% expense ratio). SCHA's average market cap lands between IJR's smaller market cap and VB's larger market cap. IJR holds about 600 names, and VB carries over 1,400 stocks, while SCHA owns 1,700 positions. SCHA and VB keep turnover low with generous buffering rules. IJR's index is run by a committee that strives to accurately represent the small-cap market while limiting turnover. Both funds earn Analyst Ratings of Gold.

Bronze-rated  Vanguard Russell 2000 ETF (VTWO) (0.15% expense ratio) holds more stocks than SCHA, but its average market cap is similar. Although SCHA and VTWO both follow rigid rules-based approaches, VTWO doesn't use buffer rules around its lower market-cap bound. And because the Russell 2000 Index has more money tied to it and dips into less-liquid securities, it can incur greater transaction costs than SCHA.

 DFA US Small Cap (DFSTX) (0.37% expense ratio) doesn't track an index, but it is a market-cap-weighted fund that invests in U.S. small-cap stocks and systematically avoids the most expensive and least profitable names in this market segment. The portfolio managers take a patient approach to trading in order to minimize transaction costs, which is especially important in the less liquid small-cap space. SCHA's average market cap is about 40 percentage points larger than that of DFA US Small Cap, which carries a Gold rating.

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Adam McCullough does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.